The Stock Market: A beginner's guide

A few years ago, I was terrified of the stock market. It seemed to me an intimidating system of numbers and vocabulary whose meanings were well beyond my level of understanding. Indeed, I recently spoke to a coworker who expressed a very similar sentiment. The stock market can seem like an extremely complex and scary place to put your money if you don't understand some fundamentals.

Talking to my coworker was like looking in the mirror a couple of years ago, when I too felt clueless and at the mercy of the financial markets. Now, having done a great deal of research and reading into the financial markets, I feel that I'm finally in a position to shed some light on the mystery of the market.

"The stock market" is a term thrown around by many people. When most people talk about "the market", they are referring to a market index such as the Dow Jones (which is a group of the thirty largest American corporations such as GE, Exxon Mobil, etc.) and they are referring to the average increase in the share price plus dividends of all the companies in this index. 

So what are the investment options for the individual investor? Many people decide to take a hands off approach, choosing a mutual fund, in which the fund manager will buy and sell stocks in an attempt to beat the market index normally charging a commission of 1-2% of the account balance per year.

Others will choose to purchase the index itself, and buy shares of an ETF (which is a fund similar to a mutual fund) that actually tracks the market index and guarantees at least market returns and charging much lower fees of <1% per year.

Others, like myself, will choose to own individual stocks, a tactic that requires a great deal more work, but also offers the possibility of greater returns and the satisfaction of a mental and often emotional challenge.

If you choose to manage your own portfolio of stocks, the most basic thing to understand is that a stock is not just a piece of paper. A stock is a share of real ownership in a corporation. Buying a stock of a company makes you an owner of that company! Ownership entitles the shareholder to a percentage of all corporate assets, liabilities, and profits.

Stocks trade on what are called stock markets, which is simply a place where shares of companies are bought and sold. Sometimes people are very confident about the future of a company, and sometimes people are uncertain about the future of a company. When a company is expected to perform well, the price for a piece of the company will normally rise in an expectation of higher earnings. When a company is expected to perform poorly, the price of the shares will normally fall as investors sell out of their current holdings.

Changes in share prices are often caused by the report of corporate earnings or growth and sometimes for no apparent reason at all. So, if the markets are as fickle as they seem, how does anyone make any money? What purpose is there to investing in stocks?

There is money to be made because stocks will eventually find an equilibrium, despite short term variation in price. Often share prices do not accurately reflect the true value of the company. Historically, stocks have traded at approximately 15 times earnings, meaning that a company making a dollar a year per share will generally be fairly valued at approximately 15 dollars. This is known as the P/E, or Price/Earnings ratio, and is generally considered to be an excellent indicator of over and undervaluation. By tracking the P/E and growth rate of a corporation, an investor can sometimes buy the shares at a discount, or sell the shares when they become overvalued.

P/E is not the only determinant of pricing, or the equation would be too simple. Another factor to consider is the company's growth rate. Generally speaking, earnings will grow as the company makes business more efficient, opens new stores, etc. A company's growth rate is generally considered to give an excellent idea of what the stock may be worth in the future 3-5 years.

Many people believe that the market will value a stock at a fair price at all times. This is known as the rational market theory, and assumes that the large brokerage firms and individual investors who are constantly tracking their investments are aware of all available information and have acted based on this information, which is then reflected in the share price.

It is my belief that the individual investor in fact has knowledge that the Wall Street investment banks and brokerage firms may not, a view also espoused by Peter Lynch in One Up On Wall Street : How To Use What You Already Know To Make Money In The Market.

Individual investors often have knowledge of corporations that they may not even be aware of. Who knows the earning power of a company better than its customers? Who knows local area companies better than those people who live and work in the local community? Often, these stocks will offer a great opportunity to beat the market averages, as they are frequently not covered by the large investment firms, and if they are, their intangibles are not well known, the same intangibles that probably brought them to your attention in the first place.